Why Congress Must Unshackle the R&D Tax Credit

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On December 31, 2013, the U.S. Federal Research and Development (R&D) Tax Credit sunsets. Again.

This time of year, every year, CFOs of Fortune 500, middle-market and small businesses wonder whether the U.S. R&D credit that they count on and budget for will be around for the next year. Executives, like you, wonder because the 31-year-old tax credit still isn’t permanent. And while that’s a problem, it isn’t the only problem with the credit. In fact, it’s hobbled in four different ways, which jeopardizes U.S. global competitiveness against countries like Russia, China, Canada and Ireland.

Combined, the four factors, the annual expiration of the credit, the alternative minimum tax (AMT) limitation, low percentage rate and methods of calculation, have contributed to our tax credit’s fall from being the number one R&D Tax Credit in the world to being the 24th. And when you figure in that other countries combine their R&D tax credit with low corporate tax rates, the deck is stacked against the U.S. for continuing to attract multinational companies to its shores or even keeping intellectual-property-rich companies here.

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For example, Ireland began offering an R&D tax credit in 2004. U.S. foreign direct investment (FDI) in Ireland jumped between 2000, when U.S. investment was $127 billion, and 2011, when it was $243 billion. In 2011, according to AmCham, U.S. foreign direct investment was 74 percent of Ireland’s inward investment. And Ireland has explained that it is looking to attract not just large U.S. FDI but middle-market and small companies too, which could start to eat into America’s major engine of job growth, entrepreneurial businesses.

It is imperative that Congress address the restrictions hemming in the U.S. R&D Tax Credit, so that more companies of all sizes can benefit from it. Removing the constraints will make the U.S. more competitive globally.

Today, 27 of the OECD’s 34 countries not only offer an R&D tax credit or incentive, but 13 of these countries also have increased the “generosity” of their credits over the past seven years, while the U.S. has remained static.

That stagnancy is a mistake. When bundled with access to markets, talent pool and stable governments, an R&D Tax Credit attracts multinational companies to locate operations in a country. Furthermore, the research and development field is known for creating high-paying jobs. Intel, for example, reportedly pays its R&D employees in Ireland on average €79,482 (about $100,000) annually. That wage is a typical amount for this type of work. More jobs and more high-paying jobs are a by-product of a healthy R&D tax credit.

The first step toward increasing U.S. competitiveness around the world is making credit permanent. If it were made permanent, companies could accurately budget for future R&D spend, giving CFOs the certainty of receiving the credit and the ability to determine proactively how to spend the saved tax dollars. Congress can’t agree on much these days, but making the credit permanent is one thing that does have bipartisan support.

Many companies use their R&D credit savings to hire additional R&D personnel, invest in new equipment and technology, engage in innovative marketing and provide employee incentives. For example, a small technology company based in Atlanta filled a critical new position in 2012 based on the $92,000 that it saved by using the federal and Georgia’s state R&D Tax Credits. As a result of filling this high-paying, yet scarce, position, the company was able to get its product to market faster and recognize revenue ahead of schedule.

Secondly, Congress should eliminate the Alternative Minimum Tax (AMT) restrictions. The R&D Tax Credit is currently limited by AMT for C-corporations at the corporate level and for flow-through companies like partnerships and S-corporations at the individual level. If a company or individual is subject to the AMT, they cannot benefit from the R&D Tax Credit they might qualify for in the current tax year. By eliminating the AMT constraint, companies and individuals who consistently find themselves in AMT year after year would actually be able to benefit from the R&D credit.

Next, Congress should increase the percentage of the R&D Tax Credit. A greater monetary benefit may attract more companies to the U.S. and encourage more companies to keep their R&D onshore. At present, the Alternative Simplified Credit (“ASC”) calculation is equal to 14 percent of the amount of the current-year Qualified Research Expenditures (QREs) that exceed 50 percent of the average QREs for the three preceding taxable years. Current legislation hopes to increase this to 17 percent, thereby improving the tax-savings benefit.

Let’s say a global pharmaceutical manufacturer increases R&D spend about 10 percent each year. In 2013, it spent $2 billion developing, testing and manufacturing new and improved products and enhancing production efficiencies. Under the ASC method of calculation, this pharmaceutical manufacturer’s credit would be $108,017,000. By increasing the percentage to 17 percent, its R&D credit comes out to $131,163,500, a substantial increase.

Finally, the government should abolish the “traditional” method of calculation. Companies can calculate the R&D Tax Credit in two ways. The traditional method is antiquated, complicated and relies on data from the 1980s. The main issue is that information that is culled from 30 year-old-data often isn’t defendable or even available. By contrast, the ASC calculation relies on base-period data from the past three years and is much simpler to calculate and substantiate. Many companies are only able to use the ASC calculation because they no longer have the necessary data physically available to support the traditional calculation.

Eliminating the choice of two different calculation methodologies allows Congress to focus legislation on the ASC method instead of being distracted by trying to improve the traditional method. If the traditional method were to be improved by Congress, that improvement would only help a select number of companies. Whereas if Congress would drop the traditional method and focus on increasing ASC to, say, 17 percent to 20 percent, it would help every company that qualifies for the tax credit.

It is important to note that these four items are interrelated. In and of itself, eliminating the traditional method will not result in a better credit for all companies. But if the traditional method is banned (in other words, if companies had only one method to choose), the ASC percentage is increased, AMT limitations are removed and the credit is made permanent, that combination of improvements would enable the U.S. to reclaim its top position among countries offering the R&D Tax Credit.

In 2010, the last year of available data, $8.51 billion was claimed by U.S. companies using the U.S. R&D Tax Credit. Manufacturers and technology, pharmaceutical and engineering companies pour R&D Tax Credit money back into operations, hire more R&D staff, hire sales teams and continue to develop new products. To keep those companies here and to attract more companies to our shores, Congress must unshackle companies from the four constraints.

If you, as a financial executive, aren’t involved in ongoing conversations with your U.S. representative about this issue, you should be. The pace that other countries are increasing the benefits of their R&D tax credit will more than likely continue to increase, weakening our tax credit even further.

Mitchell S. Kopelmanis a partner-in-charge of Habif, Arogeti & Wynne tax practice.Dawn Herman and Carli McDonald, a director and manager, respectively, of the firm’s R&D tax credit practice, also contributed to this article.